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GREECE DEBT CRISIS:

CAUSES, IMPLICATIONS AND POLICY OPTIONS
Dina Abdel Moneim Rady, Ain Shams University

ABSTRACT

Following the global financial meltdown of 2007-2008, Greece accumulated massive

deficits and public debt levels; by 2010, a sovereign debt crisis was pronounced in Greece. The
Greek government operated at a deficit of 10.4% of GDP in 2010, and in spite of a number of
euro rescue deals agreed upon by EU leaders, market volatility persisted through the end of
2011 and debt rose to 147.3% of GDP. The paper examines the probabilities of Greece default,
explores possible causes of the crisis and its implications, exploring a range of policy options to
get the country out of this crisis. The paper finds the Greece's debt crisis is a result of improper
economic policies that resulted in its high government spending and weak revenues,
accompanied with structural rigidities, and inadequate intra-euro fiscal monitoring, following its
adoption of the euro in an environment of a global recession. Greece can find its way out under
conservative assumptions, if it chooses to tackle the root causes rather than the symptoms of the
crisis, focusing on growth and productivity and ensuring that the appropriate fiscal and
structural reforms are fully implemented, which can happen only under external financial
assistance otherwise Greece could be forced to default on, or leave the Euro. The crisis
highlighted the economic interdependence of the EU, and questions the future of the euro.

INTRODUCTION

After joining the Economic and Monetary Union (EMU) of the EU in 2001, Greece ran
large deficits averaging 7 percent of GDP between 2003 and 2008. Although the outbreak of the
global financial crisis in fall 2008, the Greek government borrowed heavily in international
capital markets to fund government budget and current account deficits; as a result the
government debt grew exceptionally large. In 2009, the budget deficit reached 15.6% of GDP,
and the external debt reached 115% of GDP. The maturing debt obligations reached about 54
billion ($72.1 billion) for 2010 and the general government debt reached 147.3% of the GDP.
Both Greeces budget deficit and external debt level are well above those permitted by
the rules governing the EUs Economic and Monetary Union (EMU), which calls for budget
deficit ceilings of 3% of GDP and external debt ceilings of 60% of GDP.

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1-Greek Policy Responses

The Greek government adopted sets of procedures to confront the crisis:

1-1 Fiscal Austerity

In October 2009, the Greek government has unveiled three separate packages of fiscal
austerity measures aimed at bringing Greeces government deficit down from an estimated
13.6% of GDP in 2009 to below 3% by 2012. In total, the measures are worth an estimated 16
billion ($21.6 billion), or 6.4% of GDP. In March 2010, the parliament approved another
austerity measures which aimed to increase revenues through a rise in the average value-added
tax rate. On the expenditure side as shown in figure (1), most of the spending cuts announced
focused on the civil service. The Greek social security system has been facing chronic and
structural problems (George Hondroyiannis and Evangelia Papapetrou (2002), thus the
government decided to reduce pension funds, cuts in pay and non-pay expenses, a substantial
increase in prices for services offered by SOEs, and limits on subsidization. The government also
announced to tighten public regulation and restructure Greeces public administration by
consolidating local governance structures through reducing the levels of local administrative
authorities.

Figure (1): Fiscal measures in the medium-term fiscal strategy for 2011

Source: The Economic Adjustment Programme for Greece (Spring 2011).

European Economy Occasional Papers, Fourth Review 82

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1-2 Long term structural reform

The government announced wide-ranging reforms to the pension and health care systems
and to Greeces public administration, and boosting Greek economic competitiveness by
enhancing employment and economic growth, fostering private sector development, and
supporting research, technology, and innovation.
In spite of Greeces relatively drastic contractionary fiscal policies, and steps of the
structural reform, the economic growth rate contracted by 2% in 2009, 2.5% in 2010 and by
0.7% in 2011, and registered unemployment reached 12.6% in 2010, as shown in the table (1).

Table (1): Greece real GDP growth, unemployment rate, imports and exports (2003-2010)
Unit 2003 2004 2005 2006 2007 2008 2009 2010
Real GDP growth Annual growth % 5.9 4.4 2.3 5.2 4.3 1.0 -2.0 -4.5
Unemployment rate % of labor force 9.7 10.5 9.9 8.9 8.3 7.7 9.5 12.6
Imports of goods and services % of GDP 32.3 32.4 31.5 33.0 34.6 36.3 29.6 29.4
Exports of goods and services % of GDP 20.0 22.4 22.4 22.5 22.7 23.4 18.8 21.0
OECD data

The Greek government tried attracting new foreign investment in Greece by boosting
exports of goods and services, as well as focusing on trade and investment, shipping and tourism
sectors using its geographic location. However Greek exports dropped in 2009 to 18.8% as
shown in table (1), and Greek businesses have become increasingly uncompetitive in domestic
and international markets.

1-3 Request financial assistance

On April 2010, the Greek government requested financial assistance from other European
countries and the IMF to help cover its maturing debt obligations. However European leaders
and the IMF requested additional measures to meet budget deficit targets in exchange for
financial assistance which included economic structural reforms, while Germany and France
(which are providing the largest loan) requested sever austerity measures.
Sebnem Kalemli et al. (2010) argue that it is important to provide liquidity to the banking
sector during financial crises especially if the domestic banking sector is the main source of
financing for the firms.

2-Possible Causes of the Crisis

Greeces current economic problems have been caused by a mix of domestic and
international factors.

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2-1 Domestic Factors

- Improper Economic policies that involved high government spending and weak
government revenues

Table (2): General Government revenues and expenses

2003 2004 2005 2006 2007 2008 2009 2010
General
% of
Government 39.0 38.1 38.6 39.2 40.0 39.9 37.3 39.1
GDP
Revenues
General
% of
Government 44.7 45.5 44.0 45.2 46.6 49.7 52.9 49.5
GDP
expenditures
Source: OECD data

As shown in table (2), between the years 2003 and 2010 while general government
expenditures increased from 44.7% of GDP to 49.5% of GDP, its revenues grew only from 39.0
% of GDP to 39.1% of GDP, leading to budget deficit reaching -10.4 % of GDP in 2010, and
pointing to a large and inefficient public administration in Greece.
Between 2000 and 2009 as shown in figure (2), Greeces GDP growth rates were driven
primarily by increases in private consumption rather than investment. In addition, Greece relied
more on government employees in the production process than private sector producers and
service providers.

Figure (2): Costs of Government-produced and government funded goods and services (2000-2009)

Source: OECD National Accounts

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Weak revenue collection has also contributed to Greeces budget deficits. Many economists
suggest that tax evasion - that costs the government around 20 billion a year -and Greeces
unrecorded economy are major factors behind the deficits. Stavros Katsios (2006) argues that the
main reasons of tax evasion in Greece are high levels of taxation, corruption, excessive
regulation, and inefficiency in the public sector.

- pre-crisis trade policies in Greece

Prior to the financial crisis of 2008 Greece suffered from improper trade policies, entering
the downturn with an already weak fiscal position.

Figure (3): Evolution of the current account balance and its components (billion )

Source: National Accounts of Greece, 2000-2008.

Figure (3) shows high and increasing current account imbalances over the period 2000-
2008 leading to rapidly rising foreign obligations. Greeces gross external debt reached 149% of
the countrys GDP in 2008. In addition to high public sector debt, the private sectors debt
burden increased heavily over the period, as a result of the rapid credit expansion to households
and private businesses (Ersi Athanassiou, 2009). Greece also focused on the services sector
which is highly depended on global economic conditions. Stoyan Totev (2002) argues that the
service sector is the area through which economic relations mainly with the adjacent countries
can be realized. The evolution of Greeces external deficit reflects strong imbalances in the trade
of goods, as well as a rapid deterioration of the incomes balance.

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Table (3) shows net savings in the Greek economy over the period 2000-2007. A
negative net savings on the average reaching -2.7 % of GDP in 2008 with high public deficits
and rapidly increasing private sector debt will leave no option but to finance through external
borrowing. Greeces net annual external borrowing was on average equal to 10% of its GDP over
this period, caused a critical augmentation of the countrys external debt.

Table (3): Evolution of net saving of the Greek economy (% of GDP)

Year Net saving
2000 -0.1
2001 0.2
2002 0.0
2003 0.0
2004 1.4
2005 -0.6
2006 -0.6
2007 -2.2
2008 -2.7
Source: National Statistical Service of Greece, Bank of Greece

- Declining International Competitiveness

The current account imbalances over the period (2000-2008), reflect a serious deficiency in
competitiveness. Greece has been losing its international competitiveness due to high relative
wages and low productivity. (Rebecca M. Nelson, 2011) argues that wages in Greece have
increased from 2001 to 2010 about double the average rate in the Eurozone as a whole.
Wage agreements for 20082009 incorporated high inflation expectations, resulting in 12 %
nominal wage hikes over this period (figure 4). With inflation declining at end-2008, real wage
growth turned up, assisting household incomes. High wage growth over the euro average has led
to competitiveness deterioration.
A major factor for boosting competitiveness is concentrating on productivity through
enhancing educational outcomes. Despite progress over the past decades, educational attainment
in most age groups in Greece is below the OECD average (Education at a Glance 2011, OECD
indicators).

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Figure (4): Increase in wages in Greece (2000-2008)

Sources: Eurostat; and IMF staff calculations

3- International Factors

3-1 Recession -fall 2008

The financial crisis of 2008 caused capital markets to become more illiquid, which had its
impacts on the GDP growth and exports and hindered Greeces progress, as well as its access to
financial assistance from other countries as the crisis spread to the Eurozone. The reliance on
financing from international capital markets left Greece highly dependent on the global
economic conditions.
The Economic slowdown that faced most countries in 2008 has had its impact on
Greeces economy which faced deterioration of economic conditions bringing the real GDP
growth rate down to -2.0 %, and unemployment up to 9.5% in mid-2009 as shown in table (1).

3-2 European Integration and EU Rules Enforcement

As a result of the European integration, Greece was able to borrow funds at low interest
rates; at the same time- losing its currency- was unable to devaluate the Euro to reduce the value
of foreign debt, consequently Greece was able to accumulate this debt.

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4- Implications of Greeces Crisis

Greeces debt crisis questioned having a common monetary policy with different fiscal
policies. Some economists argue that the decision to adopt the Euro was partly dictated by non-
economic rather than economic factors.
If Greece defaults, the crisis could spillover to other Southern European countries,
including Portugal, Ireland, Italy, and Spain. These countries have borrowed heavily from
international markets and have encountered high levels of government debts as shown in table
(4).

Table (4): Debt as a percent of GDP

Greece Portugal Ireland Italy Spain
2008 118.1 80.7 49.6 114.7 47.7
2009 133.5 86.3 72.7 127.1 62.4
2010 149.1 92.9 104.9 126.1 72.2
2011 165.1 98.7 112.7 127.7 78.2
Source OECD

Greeces debt crisis has its implications for the United States as the United States and the
EU have strong economic ties, those implications involve losing confidence in the future of the
Eurozone, as the value of the euro will weaken, which can lower U.S. exports to the Eurozone
and increase U.S. imports from the Eurozone, widening the U.S. trade deficit.
Furthermore widespread financial instability in the EU could impact trade and growth in the
region, which in turn could impact the U.S. economy, as it has a large financial stake in the EU.

CONCLUSION

Greece, losing its currency, suffering from high public debt and loss of competitiveness,
in a recessionary environment and difficult economic situation in most partners, is likely to have
a debt default. Greek crisis points to the need for stronger EU economic governance, in the form
of a tighter and more enforceable Stability and Growth Pact.
The option of leaving the EU is an unlikely policy, as this would make future borrowing
costs much higher for Greece. The Greek government cannot change the obligations from euros
to New Drachmas. This would make it more expensive for the Greek debtors to repay the loans,
and could lead to bankruptcies of Greek investors, and the Greek banks associated with them.
Applying a mix of two fiscal policy tools at the same time; tax increases and sharp
spending cuts could lead to higher unemployment and more recession in the country. Greece is
facing two major economic issues; large government budget deficits (which requires
contractionary fiscal policies) and a cyclical economic downturn (which requires expansionary
fiscal policies), following the current path will involve continuing long term austerity measures

Academy of Accounting and Financial Studies Journal, Volume 16, Special Issue, 2012
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with fewer results that will end with wider recessionary gap, lower standard of living and more
political upset, causing finally more debt burden.
Greece should aim to promote export-led growth, such as wage moderation to keep the
costs of production low and make exports competitive, combined with conservative fiscal
policies that promote high levels of savings, as well as increasing an efficient privatization
process to decrease the SOEs burden on the government. However the export-led growth may be
difficult to realize under the global economic recession. Furthermore Greeces reliance on
tourism and shipping which are highly affected by economic conditions raises real questions
about focusing on trade to boost the economy.
Monetary policy can be ineffective when the banking system is in distress and fiscal
policy becomes ineffective under high levels of government debts, therefore the way to a
recovery for Greece can be in the long run under condition of financial assistance from other
countries. Loss of confidence of consumers and investors causes demand to go down, therefore
gives the government the need to step in with a demand stimulus, increasing spending on
investment rather than consumption, but it cant do that in a difficult fiscal position. The
government has to make hard choices of where it can spend money and where it can make cuts.
These decisions have to be based on accurate data and evidence about how much the
government spends what they do and how well they do it (efficiency). The outcome of the above
step will be in the long run under the condition of external finance from the EU as well as other
related countries. However Greeces reliance on external financing for funding budget can be
difficult decision since other countries will have less appetite to lend Greece while at the same
time most EU countries are themselves experiencing financial difficulties. If the financial
assistance of the other parties is not enough Greece could be forced to default on, or leave the
Euro.
Although the nature of this crisis is economic the solution can be political, as it seems
that Greece joined the EU before getting economically and competitively ready.
The Greek crisis also points to the idea that economic liberalization as a policy is not always a
blessing.

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